When creating an investment portfolio, placing all of your money into a single asset increases the risk of large-scale damage if the market takes a turn. One can decrease volatility and explore success within multiple funds by spreading assets across their investment portfolio with a personalized diversification strategy.
Daniel Fitzgerald, a certified financial planner with 30 years of experience, told Financial Professional that spreading out one’s assets can mitigate the risk associated with individual investments.
“Diversification plays a vital role in reducing risk,” said Fitzgerald. “While individual companies often falter, the overall market prevails over time historically.”
Working with a financial planner may aid in choosing the correct options for creating a personalized portfolio, but the following general practices can help you familiarize yourself with some of the most common tactics.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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Before making any investment decisions, you should consider a few factors to determine what exactly you’d like to accomplish. After all, creating a portfolio diversification strategy without a goal in mind does little to further your financial future.
It can be easy to dive deep into the exciting possibility of turning your money into more money – but all portfolios involve a bit of risk. In order to avoid spending more than you can afford to lose, set aside funds labeled as “untouchable”. You can use these funds for debt, routine payments, safe money, or padding for your emergency fund.
Are you investing for retirement, or perhaps looking to buy a house in two years? Your timeline will determine the amount of risk you’re willing to take on in your investments. It will also influence the type of funds you’d like to engage with.
Despite your timeline, you may decide there’s only so much you’re willing to put at stake with your hard-earned dollars. This is where your risk tolerance comes into play.
Note that it’s also important to involve your family, such as your spouse or other loved ones, who will be affected by your financial decision-making in the process. Ensure all parties are okay with the portfolio you or your advisors create.
Some investors enjoy crafting a mix of investments across the market. Others prefer to position their money in an industry that is up-and-coming, personally connected to them, or simply interesting. When deciding how you’d like to diversify, it may be a good idea to involve third parties who can look at your investments from a different perspective. They’ll ensure your decisions are intellectually and emotionally based.
If you’re looking to save for retirement, many employers will match contributions made to 401(k) accounts. This will accelerate the growth of your investments for the next however many years you’re planning ahead for. So before you finalize your portfolio, check what you can accomplish within your workplace.
Once you carefully determine your goals, timeline, and available options, you can take a look at the typical options explored by others.
Mutual funds offer an opportunity to invest in shares of a set of stocks, bonds, and short-term debt. Financial professionals determine the securities included and then continually monitor the fund’s performance. They are known for being affordable and liquid, meaning investors can typically redeem shares at any time without extensive fees.
Investors with long-term goals such as retirement or college funds tend to lean into mutual funds.
Said Daniel Fitzgerald, “When an investor’s time horizon is long and risk tolerance high, they can likely wait out market fluctuations. As time horizons shorten, risk tolerance is often lessened and investors feel more of a need for certainty.”
There are four key types of mutual funds to consider when crafting diversified investment strategies, each with its own benefits and downfalls.
These funds often contain low risk because they only invest in short-term securities with historically higher returns. These include securities issued by federal, state, and local governments, as well as U.S. corporations.
There are many categories of money market funds, some of which cater to retail investors (generally meant for personal investors). Others work better for institutional investors who can handle high minimum investments.
The right choice for you would be dependent on where you’d like to invest (government securities, tax-exempt municipal securities, or corporate and bank debt securities).
These securities have a higher risk but have the potential for higher rewards. Personal assumed risk is dependent on the bonds one decides to invest in, but options range from quite broad to particularly narrow.
An example of a broad portfolio would contain short- and long-term bonds in the U.S. government, agencies, corporations, and specialized securities. This type of bond fund aims to capture the activity of the market as a whole.
A more narrow bond would be one that focuses in on a particular sector of the market, for instance, a short-term bond in a specific corporation.
These funds are focused on corporate stock investment. They can be differentiated by:
Experts suggest investing in a variety of small-cap, mid-cap, and large-cap companies in order to maintain a diverse profile. Cap is short for capitalization, or the share price multiplied by the total number of stock shares.
You can decide to only invest in one type of share if you believe that it will outperform the rest of the market. This may come in the form of value stocks, small growth stocks, etc.
You can either decide to invest just in stocks from one particular country or region. Alternatively, you can select securities from around the world to hedge your bets in multiple world economies.
You can invest in securities within the same industry or spread investments throughout many sectors. Maintaining a widespread portfolio may divert from losses resulting from the crash of a specific industry.
Target Date Funds involve creating a portfolio that sets a certain goal for earnings by a particular date or event, e.g. retirement. They utilize asset allocation to divide investments between stocks, bonds, and cash investments. Then, they automatically switch up the mix over time based on your goals.
401(k) plans often offer these funds as a default investment.
While target date funds work to reach certain earnings in a particular time frame, the assets maintaining them still contain risk. Funds are not guaranteed to reach your end goal by the expected due date.
Further, each fund created contains a different set of assets. Two funds can form at the same time and have a target date of 2050. That doesn’t mean they will have the same amount in them when that date hits.
As your fund nears its end date, it tends to automatically adjust to contain less risk and hold onto funds earned so far. It’s important to continually work with a financial advisor to monitor earnings. They can help you determine a proper path forward throughout your planning process.
Upon first glance, the use of “DIY” and “funds” in the same phrase may sound a bit barbaric. However, many people have seen success by investing small asset portions into stocks they see the potential for.
So, instead of investing in a predetermined set of stocks created by advisors, you’d be choosing where to put your money based on your own expertise, interests, and predictions.
A few considerations that may be useful to keep in mind when creating a personal stock portfolio are:
ETFs stand for exchange-traded funds, which are a collection of securities such as stocks, bonds, and commodities. (Learn about the difference between mutual funds and ETFs here). They either track an underlying index (a particular area of the financial market) or employ a number of sectors and strategies.
They’re purchased and sold as marketable securities, meaning they come with associated prices that fluctuate throughout the day depending on which shares are bought and sold on the market.
ETFs are used because they are more liquid and cost-effective in their low expense ratios and fewer broker commissions, compared to buying stocks individually (like the mutual funds described above).
Your options for ETFs have a pretty wide span-from just a few U.S. offerings in one particular sector, to hundreds of thousands of various industry stocks around the world. This makes including ETFs in a diversification strategy easy for those investors who are interested in ETFs. (Of course, it’s always a good idea to ask your financial advisor first – remember: every situation is different).
This type of ETF makes past bond prices available to all investors, not just institutional investors.
People looking to trade easily and with transparency often use this method. Examples include corporate bonds, government bonds, and state and local bonds (or municipal bonds).
Stocks, bonds, and commodities in a specific market sector make up industry ETFs.
The Global Industry Classification Standard (GICS) defines the primary industries as:
This option allows you to invest in physical commodities such as gold, natural resources, or agricultural goods. Investing in a commodity means you own a set of contracts that are backed by it.
Commodities investors often fair well when inflation is high and prices soar, meaning these ETFs are a bet against the dollar. When its value decreases, yours increases. However, if investments only buy into one commodity or one sector, volatility may be high. That can result in significant losses in a short time frame.
Futures commodity ETFs are security purchases made at a set price determined before the product hits the market. For example, a January futures contract for silver may be created months prior, but will only kick into effect in January.
This type of investment vehicle helps to speculate the security’s direction, and prevent losses from unforeseen price changes. However, it’s important to keep in mind that futures contracts may be leveraged by the company. That can result in higher prices than would’ve been paid if you purchased them immediately.
These invest in foreign currencies in order to gain the funds for foreign exchange market exposure with mitigated risk. They also provide structured investment exposure to the forex market.
While including these funds in a diversification strategy may seem exciting, it’s important to remember that the success of these ETFs is largely dependent upon political trends, economic conditions abroad, and interest rates. Therefore, investors with very low-risk tolerance should be wary of any currency investments.
These allow investors to bet against the market or at least specific indexes of it. By utilizing derivatives like futures contracts, investors ensure that at about the same rate the ETF falls, they will inversely profit. These can also supplement an investor’s existing ETF to hedge their investment and further diversify one’s portfolio.
Keep in mind: If the purpose of the inverse ETF is simply to bet against an industry or the market as a whole, it can lose the individuals a significant amount of money if they are wrong in their predictions.
ETNs are similar to ETFs, but take the form of senior debt notes. The two differences between credit risk and tax benefits.
ETN earnings function as capital gain, meaning their taxes are more favorable than those of ETFs. But the payout is deferred until the security either mature or sells.
Therefore, they pose more of a credit risk: If a company you invest in goes bankrupt, the larger investors, who took on a greater tax haul, will get their return before you do.
Deciding between an ETF and an ETN comes down to a personal choice between tax treatment and credit risk.
The previous bonds discussion touched on this. To avoid being dependent on the quality of solely the domestic economy, experts suggest investing in international funds. This way, you can reap the benefits of financial success abroad.
This can further diversify one’s portfolio and ensure that a national economic downturn does not determine the fate of one’s entire set of assets.
By crafting long-term goals for one’s financial portfolio, investors may be able to take on more diversifiable risks without worrying about large-scale losses. Methods of risk assessment include:
This compares the historical risk of a particular investment as compared to its annual rate of return. It determines how much the current return differs from its expected return.
If the stock has a high standard deviation, it may be less trustworthy and more likely to result in a significant loss. This is not to say the stock is incapable of producing high return – it’s just not exactly a good ol’ reliable either. Stocks with low standard deviation are likelier to produce consistent returns.
Beta compares the risk of a particular asset in comparison to the general market. The market has a base score of 1. If the security falls below 1, it has a lower risk than the rest of the market. If it falls above 1, it has a higher risk.
This ratio helps investors determine the average return in comparison to its likely risk. By subtracting the risk-free rate from the mean return, the investor can better isolate potential profits. The greater the ratio, the better the outlook for security.
VaR aids in measuring the maximum potential loss of a portfolio or security within a specified time period. Put simply, if an investment portfolio has a one-year 20 percent VaR of $100 thousand, it has a 20 percent chance of losing $100 thousand within a year.
This method can be used in conjunction with VaR to determine the chance of it faltering and going beyond the predicted maximum threshold. Basically, this is determining the worst possible case scenario. So let’s say a one-year 99 percent CVaR is $1 million-that means that the worst 1 percent of possible scenarios would result in a $1 million loss within that year.
This final measurement determines how much a portfolio’s movement results from movement in a benchmark index. Measurements fall between 0 and 1 and typically appear in percentages. A high R-Squared (usually around 85%-100%) means the activity of its underlying index can largely explain the movement of the security. With a low R-Squared (typically 70% or less) the index’s activity cannot explain the security’s movement. The tricky part about this measurement is it doesn’t determine whether the stock is good or bad – it simply works to better explain its movement.
“Standard deviation and beta are the most commonly used measures of volatility,” said Fitzgerald. “They give us a sense of risk as compared to the overall market and what type of deviation we might experience from an expected return.”
These measurements work to measure two types of risk:
Associated with the overall market, this type is unpredictable and determined by the success of the general economy, the nature of the political environment, and numerous other factors. While this type of risk is challenging to avoid, you can manage it by utilizing a wide variety of asset classes that react differently to specific financial circumstances (such as an assortment of income, cash, and real estate).
Unsystematic risk refers to a single industry or security, so the volatility of the individual stocks or bonds you invest in determines it.
Overall, you can expect that all investments will come with a bit of risk involved. However, properly measuring and consistently reconsidering and diversifying portfolios can control that risk as much as possible.
While many look at investments as passive income, it is important to remember that portfolios require annual, or even quarterly, reconsideration to ensure that the chosen funds are successful and can be expected to remain that way for the upcoming time period.
“Periodic reassessment is critical,” said Fitzgerald. “First to reassess goals, risk tolerance, and time horizons for meeting those goals. And then to rebalance to the appropriate allocation.”
Are you still on the same track you were when you initially created your portfolio? Have you changed your plans regarding a future living space, retirement situation, or the funds you’d like to leave to loved ones?
As your budget tightens, you decide to make a large purchase, or you are near retirement, you may want to tighten the reigns on the amount of risk you’re willing to take on with your investments. Working with your financial advisor, you can adjust your portfolio to better protect your funds.
Coinciding with risk tolerance, your time horizons will determine how much risk is appropriate for you to maintain. If you are still decades away from retirement, you may decide you’d like to take on more risk as your funds are more likely to weather short-term market fluctuations. However, if you plan on retiring within the next couple of years, you may decide to hang on to what you’ve earned already and stick to funds with low volatility profiles.
It’s rarely a bad decision to plan your diversified portfolio early in life, but it is crucial that you place an emphasis on the planning part of your diversification strategy. Before rushing into any large investment decisions, determine your goals and timeline, do your research, consult the experts, and determine what plan makes the most sense for you.